National Institute of Economic and Social Research

Thursday, 2 February 2012

NIESR's UK and World Economy forecast

Our latest forecast is published today: here are the highlights. The World
Economy

• Our baseline forecast is for global
growth of 3.5 per cent in 2012. Growth will accelerate to 4 per cent in 2013,
representing a downward revision of about ½ percentage point in each year
compared to our last forecast.

• This
assumes a delayed but ultimately successful resolution of the Euro Area
crisis. Nevertheless, we expect a mild recession in the Euro Area
as a whole, as well as in the UK.

• We
forecast growth of about 2 per cent in the US this year, while China and India,
although slowing, will continue to drive world growth.

The financial instability resulting from the Euro Area
crisis, combined with fiscal austerity measures, continues to have a
substantial negative impact on growth in Europe and to a lesser extent in the
US. Monetary policy remains loose and, since October, we have seen further
easing of monetary policy, through the use of a variety of different policy
instruments, in the US, UK and Euro Area.

Our central forecast assumes that EMU remains intact,
and that a decisive agreement will be reached by the second half of 2012 that
will ensure European sovereigns are able to meet their borrowing needs at
reasonable rates of interest. The combination of this path for interest
rates, tight lending conditions, and fiscal tightening in many Euro Area
countries results in a mild recession in the Euro Area as a whole. However,
there are substantial upside and downside risks to this scenario.

Recent data have been encouraging, and we project
moderate growth in the US and Canada. In Japan, post-earthquake reconstruction
will support growth, albeit still in a deflationary environment. In China,
there is some evidence of rebalancing from exports to consumption, and we
project only a gradual slowdown.

The UK Economy

• The economy will contract very slightly (0.1 per cent)
this year but grow by 2.3 per cent in 2013.

• Consumer price inflation will fall
back to 2.2 per cent this year and 1.4 per cent in 2013.

• We expect the cyclically adjusted
current budget to return to balance in 2016–17.

• We expect unemployment to continue to
rise this year to about 9 per cent, and to remain elevated throughout the
forecast period.

The UK economy remains weak, and over the near term we
do not expect economic conditions to improve. We expect output to be flat this
year, as both the private and public sectors continue simultaneous
deleveraging. Meanwhile, while net trade provided the only significant
positive contribution to growth in 2011, the Euro Area, the UK’s largest
trading partner, is likely to enter recession.

We therefore forecast a return to technical recession
in the first half of this year, as households continue to retrench, credit
conditions remain tight, and businesses are reluctant to invest given
uncertainty about both domestic and foreign demand. Assuming a successful
resolution of the euro crisis, we expect growth to pick up in the second half
of the year, and to accelerate somewhat in 2013.

However, the output gap will be closed only very
slowly, with unemployment rising to about 9 per cent this year and remaining
high throughout the forecast period. Even in 2014, it will still be over
7 per cent, compared to the OBR’s estimate that the structural unemployment
rate is about 5.25 per cent. Unemployment at this elevated level for such a
long period is likely to do permanent damage to the supply side of the economy,
with large long-run economic costs. Our central forecast is that
inflation will fall below the 2 per cent target in the second half of this
year.

The UK economy currently suffers from deficient
demand; the current stance of fiscal policy is contributing to this deficiency.
A temporary easing of fiscal policy in the near term would boost the
economy. The credible commitment to a sustainable fiscal policy over the
longer term provides the Government with the flexibility to provide a clearly
defined and temporary boost to near-term demand. An increase in government
investment would not have a significant impact either on long-run
sustainability or – given the way they are defined – the likelihood of the
Government meeting its fiscal targets.